Answers on Credit Ratings Long Overdue

Raise your hand if you can explain why anyone still believes in credit ratings.

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Warren Buffett

One of the enduring questions of the financial crisis is how the credit ratings establishment got so much so wrong for so very long. How could century-old institutions like the Moody’s Investors Service give their triple-A blessings to subprime junk?

It is time — in fact, past time — for Washington to get some answers. Because despite talk of a shake-up, the companies that dominate the ratings business hope to avoid the radical overhaul their critics are calling for.

On Wednesday, the Financial Crisis Inquiry Commission, the federal panel that is trying get to the bottom of the financial crisis, will examine the ratings industry and its many failures at a hearing. There is no shortage of hard questions to ask, including the big one: How can we prevent these institutions and their sometimes cockamamie judgments from endangering our financial system again?

Like so much of Wall Street, the ratings industry today looks much like it did before the crisis: powerful, profitable, protected. A few new players are trying to break into the business, but the old guard — Moody’s, Standard & Poor’s and Fitch — still lords it over the industry.

The mortgage collapse exposed the conflicts at the heart of this old-line ratings oligopoly. Restaurant reviews might seem suspect if they were paid for by the restaurants being reviewed. But that is essentially how things work in the credit ratings business. Even now, after all we have learned, Moody’s, S.& P. and Fitch are still paid by the banks and companies whose securities they evaluate.

Wall Street may have a bit of hearing fatigue these days, but the one scheduled for Wednesday in New York is bound to draw some scrutiny in banking circles. Joining Raymond W. McDaniel Jr., chairman and chief executive of Moody’s Corporation , will be none other than Warren E. Buffett, who happens to be Moody’s biggest shareholder.

Mr. Buffett has been selling some of his Moody’s stock of late, but given his long and lucrative association with the company, the panel might want to know what he thinks about the ratings business, past, present and future.

This hearing could be one of the last opportunities to educate the public and Congress about how we might overhaul a system that failed the nation before the current financial regulatory reform bill is signed into law.

To that end, here are a few questions the panel might ask:

Mr. McDaniel, given the obvious failures of Moody’s and its peers, why should the major ratings companies retain the competitive advantages bestowed upon them by the Securities and Exchange Commission? Moody’s and other major agencies are designated as nationally recognized statistical ratings organizations. What advantages does this designation convey? How would business and profits be affected if this designation were revoked?

What specific changes have you made in your policies, procedures and personnel as a result of the financial crisis and your role in it? How should the government regularly test rating agencies to see if they should maintain their special status?

Defend your so-called issuer-pay model — the notion that issuers, rather investors, pay you for ratings. Senator Carl Levin, Democrat of Michigan, once characterized it as “like having one of the parties in court paying the judge’s salary.” Is Senator Levin wrong? Why is an issuer-pay model better than an investor-pay model, aside from profitability for Moody’s? Given that investors rarely are willing to pay for research, what would happen to your business and the bond industry if the issuer-pay model was outlawed?

The F.B.I. issued a warning in 2004 of “an epidemic of mortgage fraud coursing across this country.” Were you aware of it? If so, what steps did Moody’s take to ensure that the mortgage investments it was rating were not tainted by fraud? How does Moody’s detect possible fraud?

Andrew M. Cuomo, the New York attorney general and candidate for governor, is investigating whether banks hoodwinked the ratings firms. Did anyone at Moody’s worry that banks might be playing fast and loose? If so, did Moody’s stop doing business with those banks, or warn regulators? If you didn’t, why not?

William A. Ackman, a prominent hedge fund manager, recently suggested that the ratings industry adopt a “wait to rate” policy. He wants ratings agencies to wait 60 days before rating a new security, thus compelling early buyers to do their own homework. He also suggests the agencies adopt a pay-for-performance model that would reward accurate ratings. What is so bad about that?

Senator Al Franken, Democrat of Minnesota, has included a provision in the latest overhaul bill that would establish a government unit that would act as an intermediary between Wall Street banks and ratings agencies. The unit would assign agencies to rate new issues. Senator Franken hopes that would root out conflicts of interest and prevent rating agencies from competing for clients by offering higher ratings than the securities deserve. What do you make of the provision?

Last month, Moody’s disclosed that it received a “Wells notice” from the Securities and Exchange Commission in March, indicating that the commission might file a civil suit against the firm, claiming Moody’s had filed misleading descriptions about how it assigned ratings. Why did you wait almost two months before disclosing the Wells notice?

On the day Moody’s received the Wells notice, you sold $4.3 million of Moody’s shares through a previously scheduled plan. Did you consider not selling the shares? And did you alert Mr. Buffett, your largest shareholder, of the notice? His firm, Berkshire Hathaway , sold $30 million of shares in the next week.